Chapter 9
Forecasting Exchange Rates
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Chapter Objectives
•
•
•
To explain how firms can benefit
from forecasting exchange rates.
To describe the common techniques
used for forecasting.
To explain how forecasting
performance can be evaluated.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Why Firms Forecast
Exchange Rates
• MNCs need exchange rate forecasts for
their:
–
–
–
–
–
–
hedging decisions
short-term financing decisions
short-term investment decisions
capital budgeting decisions
earnings assessments
long-term financing decisions
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Corporate Motives for Forecasting Exchange Rates
Decide whether to
hedge foreign
currency cash flows
Forecasting
exchange
rates
Decide whether to
invest in foreign
projects
Home
1QA\
cash
flows
Decide whether
foreign subsidiaries
should remit earnings
Decide whether to
obtain financing in
foreign currencies
Value
1QA\
of the
firm
Cost
of
capital
International Financial Management, 2nd edition. Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA
Forecasting Techniques
• The numerous methods available for
forecasting exchange rates can be
categorized into four general groups:
1.
2.
3.
4.
technical
fundamental
market-based
mixed
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Technical Forecasting
• Technical forecasting involves the use of
historical data to predict future values.
– E.g. time series models.
• Speculators may find the models useful for
predicting day-to-day movements.
• However, since the models typically focus
on the near future and rarely provide point
or range estimates, they are of limited use to
MNCs.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Fundamental Forecasting (1)
• Fundamental forecasting is based on the
fundamental relationships between
economic variables and exchange rates.
– E.g. subjective assessments, quantitative
measurements based on regression models and
sensitivity analyses.
• Note that the use of PPP to forecast future
exchange rates is inadequate since PPP
may not hold and future inflation rates are
also uncertain.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Fundamental Forecasting (2)
• In general, fundamental forecasting is limited by:
– the uncertain timing of the impact of the factors,
– the need to forecast factors that have an
immediate impact on exchange rates,
– the omission of factors that are not easily
quantifiable, and
– changes in the sensitivity of currency
movements to each factor over time.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Market-Based Forecasting
• Market-based forecasting uses market
indicators to develop forecasts.
• The current spot/forward rates are often
used, since speculators will ensure that
the current rates reflect the market
expectation of the future exchange rate.
• For long-term forecasting, the interest
rates on risk-free instruments can be
used under conditions of IRP.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Mixed Forecasting
• Mixed forecasting refers to the use of a
combination of forecasting techniques.
• The actual forecast is a weighted average
of the various forecasts developed.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Efficient Markets Approach
• If Financial Markets are efficient prices reflect all
available and relevant information.
• If this is so, exchange rates will only change when
new information arrives, thus:
St = E[St+1]
and
Ft = E[St+1| It]
• Predicting exchange rates using the efficient
markets approach is affordable and is hard to beat.
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Alan Greenspan
• “My experience is that exchange markets have become so efficient
that virtually all relevant information is embedded almost
instantaneously in exchange rates to the point that anticipating
movements in major currencies is rarely possible.
”…Despite extensive efforts on the part of analysts, to my
knowledge, no model projecting directional movements in exchange
rates is significantly superior to tossing a coin. I am aware that of the
thousands who try, some are quite successful. So are winners of
coin-tossing contests.
"The seeming ability of a number of banking organizations to make
consistent profits from foreign exchange trading likely derives not
from their insight into future rate changes but from market making.”
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
DNB still forecasts…
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Forecasting Services
• The corporate need to forecast currency
values has prompted some consulting
firms and investment/commercial banks
to offer forecasting services.
• One way to determine the value of a
forecasting service is to compare the
accuracy of its forecasts to that of
publicly available and free forecasts.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Evaluation of Forecast
Performance (1)
• An MNC that forecasts exchange rates
should monitor its performance over time to
determine whether its forecasting procedure
is satisfactory.
• One popular measure, the absolute forecast
error as a percentage of the realized value,
is defined as:
| forecasted value – realized value |
realized value
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Absolute Forecast Errors over Time
Using the Forward Rate as a Forecast for the British Pound
Evaluation of Forecast
Performance (2)
• MNCs are likely to have more confidence
in their forecasts as they measure their
forecast error over time.
• Forecast accuracy varies among
currencies. A more stable currency can
usually be more accurately predicted.
• If the forecast errors are consistently
positive or negative over time, then there
is a bias in the forecasting procedure.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Forecast Bias over Time
for the British Pound
Graphic Evaluation of Forecast Performance (1)
Realized Value
z
Region of
downward bias
(underestimation)
Perfect
forecast
line
Region of
upward bias
(overestimation)
x
x
Predicted Value
z
Graphic Evaluation
of Forecast Performance (2)
• If the points appear to be scattered evenly
on both sides of the perfect forecast line,
then the forecasts are said to be unbiased.
• Note that a more thorough assessment
can be conducted by separating the entire
period into subperiods.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Forecast Bias in Different Subperiods
for the British Pound